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How Do I Know If My 401(k) Is Top-Heavy?

Do a few people in your 401(k) plan have the majority of the money? If so, the IRS may require you to do something about it.

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According to Internal Revenue Code Section 416, a company 401(k) is considered top-heavy if more than 60 percent of the total 401(k) plan balance is held by key employees.

A “key employee” is defined as:

  • An officer receiving over $185,000 in 2020 or 2021.
  • An owner of more than 5% of the company.
  • A spouse, child, parent, or grandparent of someone owning more than 5% of the company.
  • More than a 1% owner with annual compensation exceeding $150,000.

The IRS takes the approach that all workers should have equal opportunity to set aside money for their future – not just key employees or business owners. For this reason, small business 401(k) plans are generally required to pass a series of nondiscrimination tests each year, including the top-heavy test.

How Common Are Top-Heavy Plans?

Small business 401(k) plans, especially those with high turnover, are more likely to be considered “top-heavy” than large business plans. Bigger plans have more employees who are not management-level or higher, whereas smaller teams that have grown as an extension of a business owner or spouse duo will have the ratio slanted against them unless there are contributions made to the rank-and-file workers.

Top-heavy test failures are not only the most common, but the costliest to correct, so it’s important to know whether your 401(k) is likely to be top-heavy or not.

When Will I Know If My 401(k) Plan Is Top-Heavy?

The determination dates are the first and last days of the plan year, so December 31st. This means that a plan failing the first year will also be top-heavy for the following year.

How Is Top-Heavy Status Calculated?

  • Consider which participant balances are excluded – such as those with rollover accounts from past employers or the balances of terminated employees.
  • Add on distributions made on account of termination, retirement, loans or early distributions, and death.

How Do I Know I’ve Passed a 401(k) Top-Heavy Test?

If you’re worried about the top-heavy test, you can:

  • Encourage non-key employees to increase their contributions by providing educational materials.
  • Incentivize participation with a modest matching contribution.
  • Request that key employees reduce or cease their contributions.
  • Make a profit-sharing contribution to all employees.
  • Allow previously ineligible participants into the plan by removing the vesting schedule.
  • Add a mid-year Safe Harbor Match, now allowed under the SECURE Act.

Some steps will NOT help you pass testing. For instance, you can’t take a mid-year disbursement, which the IRS expressly forbids. You also can’t simply terminate or demote a key employee, as all funds contributed so far are still factored in. Additionally, you can’t cancel the plan or make a correction for funds already contributed.

What Can Be Done to Pass a 401(k) Top-Heavy Test?

One of the best ways to pass a top-heavy test is to add a Safe Harbor provision to your plan. You may choose to:

  • Contribute a 100% match on the first 3% of saved dollars and 50% on the next 2%,
  • Contribute a flat 3% of each non-key employee’s salary, OR
  • Match the highest contribution percentage of any key employee

Best of all, employer contributions are tax-deductible. You have until October 1st for the Safe Harbor provision to go into effect at the start of the next year.

For help in choosing the right type of 401(k) plan for your small business, contact Ubiquity to schedule a free consultation. Attract and retain your workforce with our uncomplicated, flat-fee retirement savings plans.

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44 Montgomery Street, Suite 3060
San Francisco, CA 94104
Support: 855.401.4357

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© 2023 Ubiquity Retirement + Savings
Privacy Policy
Do not sell my info
44 Montgomery Street, Suite 3060
San Francisco, CA 94104
Support: 855.401.4357

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